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Financing Organizations
Vysoká škola finanční a správníWinter Semester 2013
Jaromír R. [email protected]
Course
• Eleven lectures + twelve seminars• Seven credits• Ends with the exam• The course explains the nature, advantages, costs
and risks of classic and alternative external sources of company financing
• It builds on knowledge acquired during previous studies of corporate finance and accounting
Literature
• Tichý, Jaromír: Zdroje financování podniku. 1. vyd. Praha: EUPRESS, 2012. 100 s. ISBN 978-80-7408-070-8
• Block, Stanley B., Hirt, Geofrfrey A., Bartley B.R.: Foundations of Financial Management 13th edition, Boston: McGraw-Hill Irwin 2009ISBN 978-0-07-128107-2
• Schroeder, R. G.: Financial Accounting Theory And Analysis: Text And Cases Hoboken: John Wiley and Sons, 2009
Grading
Exam:
• Credit by David Muir, M.B.A. required• Pre-term: written test, multiple choice (will be
offered only once) Dec. 18th, 2013 2:30 pm• Regular term: oral exam
Course Layout
1. Internal sources of financing, working capital management
2. Reasons for financing by external sources
3. Trade credit
4. Bank loans and other services
5. Financial investments, venture capital, silent partner
6. Strategic investments, mergers and acquisitions
7. Capital markets, stock, bonds, derivatives
Balance Sheet
Assets LiabilitiesCurrent Assets Current LiabilitiesCash and Equivalents Short-Term Accounts PayableShort-Term Receivables Current Tax PayableInventory Short-Term Loans and BorrowingsAccruals and Other S/T Assets Accruals and Other S/T Liabilities
Long-Term Assets Long-Term LiabilitiesIntangible Fixed Assets Long-Term PayablesTangible Fixed Assets ProvisionsLong-Term Receivables
Owners’ Equity Share CapitalShare Premium and Capital FundsRetained EarningsY-T-D Profit (Loss)
Balance Sheet Assets Liabilities
Long-Term Assets Long-Term LiabilitiesIntangible Fixed Assets Long-Term PayablesTangible Fixed Assets ProvisionsLong-Term ReceivablesCurrent Assets Current LiabilitiesCash and Equivalents Short-Term Accounts PayableShort-Term Receivables Current Tax PayableInventory Short-Term Loans and BorrowingsAccruals and Other S/T Assets Accruals and Other S/T Liabilities
Owners’ Equity
Share CapitalShare Premium and Capital FundsRetained EarningsY-T-D Profit (Loss)
Working Capital Structure+ accounts receivable+ inventories+ cash & equivalents____________________________________________________________________________________________________________________________________________________________________________________________________
= WORKING CAPITAL- accounts payable __________________________________________________________________________________________________________________________________________________
= NET WORKING CAPITAL- cash & equivalents
__________________________________________________________________________________________________________________________________________________
= NON-CASH WORKING CAPITAL
Need for Working Capital• WC is tied in the flow cycle• Amount of WC needed can be understood as
- average need per period (year, month)- instant need- maximal need during a period (season)
• To know the need for WC is essential for planning, securing operational financing, budgeting and capital investment planning
WC Management Goals• Optimize its volume in respect of operational needs• WC management represents individual management
of its segments• Zero non-cash working capital • Role of financial manager
- WC management is one of the most time-demanding task of the financial manager‘s team- good WC management represents significant savings in financial costs
Material ProductionFinished
goodsAccounts receivable
10 days 20 days 10 days 30 days
Accounts payable
30 days
40 days
Payment to suppliers
Payment from
customers
Need for Working Capital
need to finance by working
capital
Working Capital Flow Cycle
Inventory of finished products
Accounts receivable
Raw material inventory
WORKING CAPITAL
Procurement
Production
Warehousing
Logistics
Sales
Collection
Accounts Receivable TurnoverAccounts receivable / avg daily sales (sales / 365)
Example:annual sales = 25 000 000 CZKaccounts receivable = 1 800 000 CZK
Calculation:average daily sales: 25 000 000 / 365 = 68 493 days of sales outstanding: 1 800 000 / 68 493 = 26
Days of sales outstanding (account receivable turnover) is 26 days
Financial Leverage
2 firms: exactly the same• Same sector• Same opportunities• Same Management…
The only difference: the debt• L (leveraged firm) has 50% of debt• U (unleveraged firm) has no debt
Financial LeverageFirm U Firm L
Shares (Capital)Financial debt Total
100 000 0100 000
50 000 50 000100 000
Number of shares(Price of a share 100)
1 000 500
EBIT Financial interests(interest rate 5%)Net income before taxEPS before tax
10 000 0
10 000 10 (10 000/1 000)
10 000 2 500
7 500 15 (7 500/500)
Net income after tax(Tax rate 33%)EPS after tax
6 700
6,70
5 000
10,00
Financial LeverageFirm U Firm L
SharesFinancial debtTotal
100 000 0100 000
50 000 50 000100 000
Number of shares(Price of a share 100)
1 000 500
EBITFinancial interests(interest rate 5%)Net income before taxEPS before tax
0 0
0 0
0 2 500
-2 500 -5
Net income after taxEPS after tax
0 0
-2 500 -5
Financial Leverage
For leverage to be profitable, the rate of return on the investment must be higher than the cost of the borrowed money
ConclusionLeverage can create value or destroy itTo create value, the IRR must be higher than the cost of loan; if not, leverage destroys value.
Short-Term Loans
Less risk for the bank hence less expensive than long term loans
• Overdraft protection: used as needed, interest on used portion only, “commitment fee“ makes it expensive
• Lombard loan: collateral, fixed amount for fixed period of time
• Revolving loan:automatic renewal, behaves like a long-term loan
• Factoring: purchase of accounts receivable
Long-Term Loans• Operational Loan:
financing of assets long-term tied in operations• Investment Loans:
project financing, leasing, capital investments• Forfaiting:
purchase of long-term receivables • Mortgage:
long-term loan typically secured by real estate• Syndicate loan:
cooperation of more banks on a giant project
Hedging• Vyhodnocení rizika: velikost expozice, senzitivita expozice, stanovení několika scénářů
včetně worst-case versus cena za službu hedgingu
Výpočet pravděpodobnosti dopadu expozice:
Scénář VýsledekPravdě
podobnostDopad
1 +40 30% +122 -3 30% -13 -65 40% -26
Celkem -15
When to Use What SourceRe
venu
e /
Profi
t
Time
Beginning
Grow
th
Expansion
Maturity
Silent partner,Venture capital,Business Angel
Bank loans, Leasing
Acquisition
IPO
Crowd financing
EUROSTAT Statistics (2012)
The most serious problems of business beginning:• Legislation• Customers• Pricing• Qualified personnel
The most serious problems of further business development
• Accounts receivable• Payroll cost• Lack of bank financing • Business vs. personal life
Business financing is the 3rd largest problem of starting enterprise
Financial Investments
• Financial investor, silent partner, business angel
• Crowd financing
• Venture capital in the Czech Republic
• Criteria and investment process
Crowd-Funding Sites• Websites to raise money by selling products not yet
fully developed or setting up own fundraising pages• KickStarter, Indiegogo, RocketHub, GoFoundMe,
Razoo, Crowdrise and many others • Easy to use, need a good product or idea,
presentation (video)• Newest way of mass business financing • Booming as we speak• Prepayments increase cash but also liabilities
Financial Investor• Mid-term investment in equity• Mutual funds or single investors• Investments into quick-growing firms with interesting
business plan• Suitable for companies with a good potential for
growth, interesting product, competitive advantage, market, capable team, and willingness to accept a financial investor as a business partner
Financial Investors‘ Criteria• Complex business plan• Management• Suitable product• Quality od revenue• Market• Investment horizon• IRR• Exit
Investment ProcessPhase Needed information Duration
(weeks)
I. Preliminary evaluation of inv. opportunity
• Discretion contract• Basic company info,
financial plan
1 - 2
II. Evaluation • Business plan 2 - 3
III. Cooperation Agreement • Term sheet 2
IV. Due diligence • Questionaire, documentation, data room
1 - 2
V. Binding contract of cooperation + financing
• Binding contract,• Draft of final contract
1
VI. Contract signature, release of funds
• Final contract 1
Total 8 - 11
Reasons for Non-Agreement• Different investment horizon• Too optimistic business plan• Company needs short-term financial help• Personal relationship doesn‘t work• Owners are not ready to give up 100% ownership
Silent Partner• A person or a company, not disclosed to others• More silent partners can invest in one company• Regulated by the Commercial Code
(Citizens‘ Code starting 2014)• No new subject• Right to have access to financial statements and
accounting records
End of Silent Partnership
The contract ceases to exist if:• It expires• Both parties mutual agreement• Silent partner‘s loss exceeds the funds put in• Bankruptcy of either party
Venture Capital• Financing into equity• High risk hence high return expectancy• Often minority partner with veto power• Seeks for attractive business plan and good
management• Exit usually in 3-5 years
Business Angel• Sole investor• Usually male 50+• Reasonably wealthy• Became rich by own entrepreneurship• Hobby business• Invests in something he knows
Why Business Plan• To approach a bank or a financial partner
- many banks made wrong calls in the past- dot com rush 2004, mortgage rush 2007
• For own use- to understand the goals and the path- see problems and barriers- time set
• For employees- they understand the consequences- build team, unify effort
How• Clear concept, trransparrent• Visual, interesting, captivating• Concrete• Identifies income sources in time
Good Impressions• Scalability• Unique selling points• Trade marks, intellectual property• Working projects, need of capital for expansion• Description – advantage – proof• Barriers of entry• Investment having direct impact on growth and
advance• Assertive and capable management
Bad Impressions• Too sensitive to criticism• Obsolete business plan• New money to cover old sins• Too high reward for owners• Overstated value of enterprise• Unrealistic forecast (ice-hockey stick graph)• Fog
Versions• Elevator pitch (1 min)• Executive summary (1 page)• Abridged version (several pages)• Full version (full lenth)
Elevator Pitch
Oral short presentation of- my idea- how far I am- who is the team- what are the markets- my advantages- how will be financed, how much I need- expected returns and when
Full Business Plan
1. Executive summary:very brief and very concrete
2. Company and teamhow long in existence, key players, CVs, contact
3. Idea / product / servicedescription what, in what sense unique, concrete results
4. Market and competitionSWOT, demonstrated knowledge of market situation, advantages / disadvantages over competition
Full Business Plan
5. Marketing and selling strategyplan how to attac the market, geography, marketing campagne, time horizon
6. Finacecurrent situation, fin. statements incl. cash flowbudget based on plan of sales, capital investmentsneed for investments, what for, how much, whenexpected returns, accented cash flow
7. Conclusionrealistic exit plan, options, summary
8. Appendices
M&A• Strategic investment into other company
- purchase of 100% or less- becomes daughter (acquisition) or merges with the investing company
• Buyerseeks portfolio diversification, market share, know how, expansion, better utilization of working capital
• Merging companyseeks stability or prestige of a larger company, new growth possibilities, know how, exit
Acquisitions
The purpose of M&A should be to create value.
Not to buy earnings or EPS.
Not to buy growth for the sake of growth.
Not to buy market share.
Not to diversify (i.e., reduce risk).
How do managers create value?
1) Managers are entrusted with capital2) They invest the capital in assets3) The assets generate earnings (and cash flows)4) The earnings provide investors with a return on capital5) Managers create value if the return on capital exceeds the cost of capital
M&A involves the use of investor capital
• The acquiring firm uses its investors’capital to acquire the target company (more specifically, the assets of the target company) • As with any other use of capital, managers create value for investors if the merger or acquisition generates returns on the capital employed that is greater than the returns investors require to compensate them for the risk of investing in the target company
Can two firms after acquisition accomplish things that separate firms
cannot?
• Higher revenue?
• Lower costs?
• Better management of working capital?
Specifically, are the cash flows likely to be greater than the sum of the cash flows of two separate firms?
i.e., is 1 + 1 > 2?
• If not, the deal does not create value.• If yes, the incremental cash flows reflect the deal’s “synergies.”
(Many examples of when 1 + 1 < 2)
What kinds of deals involve positive synergies?
1. Many horizontal deals– deals involving two firms in same industry
2. Some vertical deals – deals involving producers with distributors
3. Few conglomerates– deals involving firms in unrelated industries
Strategic Fit
Recurring Revenue
Growth Potential
Cultural Fit
Management Strength and Retention
Acquisition Criteria – What to Look For
Strategic Fit: Ask Yourself
Increased Market Share?
Expand or Strengthen Service Offerings?
Expand Geographic Presence?
New Vertical Market?
Absorb a Competitor?
Recurring Revenue
• 80% or more Recurring• Unique skills or services giving rise to
new recurring revenue
Growth Potential
• Capable of meeting 20/20 goal– 20% revenue growth– 20% profit growth
• In service sector with growth potential
Cultural Fit
• Single most important factor
• What describes the culture?– Customer Oriented– Accountability– Incentive Based– Financially well-run– Ethic– Employee Satisfaction
Management Strength and Retention
• No Management Rebuilding
• Current Management:– Capable– Willing to Stay
Employees‘ Reaction Risk• Employees tend to apprehend changes negatively• The best ones are the first ones to be headhunted• Merging cultures may be tricky
Solution:• Thorough preparation by the HR, confidential• After announcement, concrete communication
followed by quick action towards stabilization
Time Value of Money Principle
Time is money and value of money changes as time passes. $1 invested today can generate profit, uninvested looses its value
with inflation
$1 today ≠ $1 in one year
Future and Present Value
Future value: FVn = PV * (1 + i) n
Present value: PV = FVn * 1/(1 + i)n
Net present value: NPV = FVn * 1/(1 + i)n - I0
FV: Future ValuePV: Present Valuei: interest
I0: Initial investment
Internal Rate of Return
IRR is a discont rate for NPV = zero.Represents rentability percentage rate of a concrete project,
activity, or business conduct.
FVn * 1/(1 + i)n - I0 = 0
For investment longer than two years is not possible to calculate directly. Use narrowing margins method. Must contain positive and negative values.
What‘s IRR of a project with initial investment of $1.000 and 1st year profit of $452, 2nd year $500 and 3rd year $278?
Securities
• Securities - bonds - shares
• Advantages / disadvantages - attractive for investors (liquidity)
- less expensive source of financing- high initial costs
• Capital markets - NYSE ($22 trillion per year) - European: London (7 trillion), Frankfurt (3 trillion) - Central-East Europe: Warsaw (tens of IPOs yearly, pension funds), Prague (0,04 trillion = 6 hrs of NYSE trading)
• Primary and secondary trade
Balance Sheet
Assets LiabilitiesCurrent Assets Current LiabilitiesCash and Equivalents Short-Term Accounts PayableShort-Term Receivables Current Tax PayableInventory Short-Term Loans and BorrowingsAccruals and Other S/T Assets Accruals and Other S/T Liabilities
Long-Term Assets Long-Term LiabilitiesIntangible Fixed Assets Long-Term PayablesTangible Fixed Assets ProvisionsLong-Term Receivables
Owners’ Equity Share CapitalShare Premium and Capital FundsRetained EarningsY-T-D Profit (Loss)
Bonds• Marketable debt contract
- par value, cupon rate, maturity date - investor: no voting right, no management participation - issuer: received funds are listed as debt - debt: secured (senior, junior), unsecured
• Paper form / dematerialized• Retirement
- sinking fund - call option - conversion
Bond Price Calculation• Sum of incoming coupon payments plus par value converted
to present value• „i“ in PV calculation consists of risk free + risk premium• Rating - worse rating increases risk premium• Rating agencies S&P, Moody, www.rating.cz
Rating Examples
AAA BBB CCC
EBIT / fin. exp. cover x 25,5 6,5 0,9
EBITDA / fin. exp. cover x 23,8 4,7 0,4
Operating profit / tot. debt % 203,3 35,9 5,0
Operating cash flow / tot. debt % 127,6 17,3 -2,1
Total debt / EBITDA x 0,4 2,2 7,9
Recovery of investments % 27,6 13,4 3,2
Tot. liability / tot. assets % 12,4 42,5 113,5
Example of Bond Price (Par value 1.000; maturity 5 years; coupon rate 10%)
YearPayment
5% 10% 15%
1 100,00 95,24 90,91 86,96
2 100,00 90,70 82,64 75,61
3 100,00 86,38 75,13 65,75
4 100,00 82,27 68,30 57,18
5 100,00 78,35 62,09 49,72
5 1 000,00 783,53 620,92 497,18
Total 1 216,47 1 000,00 832,39